When you are the sole owner of a business, there is relatively no ambiguity as it relates to the decision making process for the business. You are able to make decisions relating to company growth and changes. You are also allowed to dictate what should happen to the company should something happen to you, or upon your exit of the business into retirement. When there are multiple owners (even if not a large amount), there is automatically added ambiguity as to what will happen to the business in the event that circumstances lead to a vacancy in the position of a stakeholder. What happens to the previous owner’s shares of the business? How much is their share worth? In the event that an owner passes away, how should the owner’s family be compensated for that individual’s stake in a business? A buy-sell agreement is a contractual agreement that supplies a framework to answer all these questions, in addition to ensuring all parties involved in the transfer of business shares don’t become overwhelmed with advantageous financial disputes.
What is a Buy-Sell Agreement?
Buy-sell agreements are legal contracts between companies, company owners, and owners’ families, that describe in the event that an owner’s position is left vacant, how their shares should be reallocated, and for what cost. Owners may need to surrender their shares of a business for a variety of reasons including sickness, death, or retirement. Buy-sell agreements contractually dictate the process by which a company is able to repurchase a previous owner’s stake in a business and distribute their shares to other owners in the company. How the shares should be reallocated is stated in the buy-sell agreement, and is normally based upon a formula that is also communicated in the contract.
What kinds of issues do buy-sell agreements help to alleviate? Until a business encounters a point in the road where they need to consider repurchasing an owner’s shares, the reason behind such agreements may seem confusing. We’ll use a hypothetical example of an owner’s retirement to accentuate some of the problems buy-sell agreements seek to eliminate. To start, after an individual exits a company, the business’ valuation may significantly decrease compared to what it was previously worth. This could make the previous owners share of the business that needs to be purchased worth significantly less, which would mean that they take much less money with them into retirement.
More problems come into play when we think of the cost associated with the business repurchasing the retired owner’s stake in the company. Especially for small businesses, it may be particularly problematic if the company doesn’t have enough liquid assets to make the repurchase. This not only puts the financial viability of the business at risk, but could also hurt the retirement prospects for the previous owner, who no longer has a source of income, and is not receiving their allotted share of money for their stake in the business. Some owners may be in a better financial position to purchase the previous owner’s shares than others, which could also lead to unequal or unadvantageous distribution and power of the company. Buy-sell agreements determine, in advance, how the owner’s shares will be paid for, at what price, and by whom. Especially in high-emotion times such as the death of a company owner, buy-sell agreements help to eliminate poor decision making that results from circumstances of elevated self-interest and financial vulnerability.
Types of Buy-Sell Agreements
Depending on the size of your business, the number of owners/shareholders, and how the shares of the company are distributed to owners, there are three specific types of buy-sell agreements that may apply to your business: Cross-Purchase Agreements, Redemption Agreements, and One Way Buy-Sell Plans.
These types of buy-sell agreements are best suited for small businesses or businesses with relatively few owners. Cross-purchase agreements set out guidelines for how enduring company stakeholders should purchase the stake of an individual who has exited the company whether through retirement or otherwise significant life changes that no longer allow the individual to make meaningful contributions toward the company’s growth. Guidelines for how the shares should be distributed and purchased may rely on a variety of determinations spelled out in the contract. For example, enduring shareholders may have the previous owner’s shares distributed to them in proportion to their previous proportion of company ownership.
Even for small businesses, repurchasing the shares from a previous owner could be a significant financial burden. As such, most buy-sell agreements include the purchase of life insurance policies on other company owners, by the owners. For example, a company with 2 owners requires a purchase of a total of 2 life insurance policies (1 policy purchase by each of the owners on the other individual). Increase the number of owners to 3, there is already an increase of total life insurance policies purchases to 6 (2 policy purchases by each of the 3 owners on the 2 other owners). Hence, cross-purchase agreements are a better buy-sell agreement option for small businesses with relatively few owners.
In the event that a previous owner passes away, if the company or current owners are unable to repurchase the company stake from the previous owner’s heir, there is a high potential that the heir does not have the relevant professional talent to assume the ownership role the previous owner once had, which could devalue the company significantly. These life insurance policies are not only important for the fact that it allows the company to remain in control of all company shares and look out for the company in the future, but it allows the previous owner and/or their family members the compensation that is owed to them that may be essential to their financial health, especially in the event of a family member’s death.
Since redemption agreements are a better option for business with more than 3 owners, and the focus of this article is buy-sell agreements for small businesses, we will focus a little less on this type of agreement. However, it is always important to understand the options that are available before moving forward with a decision. Redemption agreements dictate that the purchase of a previous owner’s share of a business should be made by the business itself. The company takes out individual life insurance policies on each of the company stakeholders in proportion to the stake that each owner holds. This can significantly cut down the number of life insurance policies involved in the process, and also ensures that each owner is paying an equal amount for insurance premiums (which may be unequal in cross-purchase agreements on the basis of employees differing in age and relative healthiness).
One Way Buy-Sell Plans
These types of buy-sell agreements are more likely encountered with small businesses, once again because of the small number of company stakeholders. These plans are best used when a company owner would like a specific individual to take ownership of their stake once they pass away, become disabled, or otherwise leave their position vacant. This is most frequently a spouse or child who will inherit their shares of the business, who therefore must take out a life insurance policy in proportion to the cost of their stake. The premiums for these life insurance policies may be paid by the beneficiary or the business entity itself.
Another circumstance one way buy-sell plans could come into play would be in business relationships where there are multiple owners, yet it only makes sense for one party to buy out the other. For example, in a small business with two owners, if their respective stake in the company totals to 40% and 60%, the majority stakeholder doesn’t benefit from a buy-sell agreement because they’re already able to vote out the other owners. In contrast, the owner with a 40% stake would be able to benefit from a buy-sell.
Business partnerships have the potential to start and stay healthy, they just as equally have the potential to sour over time. While it is nice to think the partnerships we may start with friends, family members, or other business partners will maintain positivity, human-nature and the influence of money has the potential to let ulterior motives sneak into the process. Buy-sell agreements (no matter the type that you select specific to your need) should be put in place well in advance of when they are needed. In doing so, you’ll be able to protect the interest of all parties, and preserve ownership distribution and protocols should a situation lead to a strained relationship between individuals with different levels of company stake.
Determining Business Valuation
Just as important to the determination of what should be done with an individual’s portion of company stake, the buy-sell agreement should include stipulations for how their portion of shares should be valued, which is based upon the valuation of the entire business. A variety of methods are utilized that may be more or less advantageous to small businesses based on their plans for growth in the future. Some of these valuation methods include fixed price agreements, formula agreements, and third party business valuation agreements.
Fixed-price agreements may be the least attractive option for small business buy-sell agreements considering the large potential for the business to grow in size and value, long-term. Fixed-price agreements for business valuation dictate the exact price the business will be worth when the point comes to determine a past-owner’s value of company stake in the future. Since businesses are rarely static in size and value, if you are putting your buy-sell agreement in place long before you need it (as you should), this could lead to large under or overvaluations. Improper valuation could lead to a variety of issues including not having enough assets to cover the cost of the reacquisition of company stake, or paying too much in insurance premiums compared to what you will actually need to reacquire company stake. Fixed-price agreements are best for individuals who want absolute transparency in how much the business will be valued in the future, and therefore will know exactly how much to pay for the respective owner’s life insurance policies.
Formula agreements are a much better business valuation model for small businesses that are likely to expand in the future. Formula agreements will base the value of the business on when the buy-sell agreement is ‘activated’ upon the vacancy of a company owner. Therefore, formula agreements will provide an exact formula or guideline for company performance metrics and values that should be taken into account at any point the business needs to be evaluated to understand what a previous owner’s company stake is worth.
Even if your company doesn’t grow or shrink a great amount from the time that the buy-sell agreement is put in place and when it is used, the valuation will still be accurate and account for the flexibility of the business, especially in the case of small businesses that may have expanded in size over time. While the exact value is not stated in the agreement, all parties are still aware of the criteria used in the determination of business value. Still, a potential downside of formula agreements could be the flexibility of factors that a business might use to determine its value over time if there are significant shifts in the company structure. This could lead to inaccurate valuations in the future.
Third-Party Business Valuation
One of the most accurate (and as a result, most expensive) options for valuing your business, would be to hire a third-party expert to conduct the valuation at the point the buy-sell contract is ‘activated.’ This allows the valuation decision to be made without bias, and without reliance upon values or metrics that may have become outdated from the time the buy-sell agreement was originally made. These types of agreements therefore understand that determining the value of a business at some point in the future is extremely difficult, if not impossible to accurately predict. For small businesses looking to grow or expand, this could be a difficult option to consider in relation to the fact that it may be difficult to determine the size of life insurance policy that should be purchased on each respective owner without previously knowing the accurate value of the business.
Each business relationship is different and comprises varying numbers of owners, valuations determinants, and different employee dynamics surrounding the tactility of determining when and how ownership is exited and passed along to other individuals. Putting a buy-sell agreement in place long before it’s needed can help to give you peace of mind that the business you’ve worked so hard to build and maintain will continue to succeed in the future, in accordance with an outlined structure of transition that will maintain the integrity of all parties involved. Consider putting a buy-sell agreement in place for your small business today, as an investment of time and resources for the continued success of your business and its owners for many years of expansion to come.
If you need help setting up a buy-sell agreement get in touch with us today! CFA specializes in working with small business owners for all of their financial needs.